What Type Of IRA is right for you?
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Almost thirty years ago in 1974, Individual Retirement Accounts were introduced with the enactment of the Employee Retirement Income Security Act (ERISA). As our congress drafted up the idea of the IRA account, individual participants could contribute at the time up to $1,500 per year and reduce their taxable income by the amount of their personal contributions. In the beginning, IRA’s were restricted to workers who were not covered by a qualified employment-based retirement plan. The laws have changed several times around IRA plans, but the question now is should you open an IRA and what type of IRA plan is right for you? Here are four types of IRA’s to consider:
What is a Traditional IRA?
A regular or traditional IRA is the most common type of IRA for individuals. If you have earned income and are younger than age 70½, you’re eligible to contribute to a traditional IRA. For 2013, you can contribute an amount equal to your taxable income up to $5,500 or up to $6,500 if you’re age 50 or older.
The major advantage of a traditional IRA is that your contributions are tax-deductible if you meet certain income limitations. For those that make higher levels of income, you can always contribute to a traditional IRA, but you may not be able to deduct it due to your income level. You can generally defer taxation in these accounts until you begin taking distributions after the age of 59 ½. If structured appropriately, you may be able to get the money before 59 ½ without paying the 10% IRS penalty. You can generally invest these in almost any financial institution of your choice.
What is a Roth IRA?
A Roth IRA is the second type of IRA for individuals. In this type of IRA, contributions are NEVER tax deductible. Although you must pay tax up front, there is no tax EVER on the dollars again as long as you follow the distribution rules correctly. Additionally, there’s no requirement to take minimum distributions at age 70 ½.
The one hitch with Roth IRA’s, is that if you make more than $127,000 modified adjusted gross income (MAGI) or $188,000 MAGI as a married couple, you can make no Roth IRA contribution at all. Just like the traditional IRA, you can use almost any financial institution of your choice for investing.
What is a Rollover IRA?
A Rollover IRA is an IRA that is used to hold assets that have been distributed from an employer’s retirement plan, such as a 401(k) or Profit Sharing Plan. There is no limit on the amount of money you can rollover. (source:buyandhold.com). For most of you, these types of rollovers will be done by doing a direct rollover of your 401(k) (or Roth 401(k)) when you leave your employer. The IRA account will generally give you more investment options than you would normally have in your employer’s 401(k) plan. The Rollover IRA also gives you the ability to re-roll the assets into a new 401(k) should you ever choose to do that at some point down the road.
What is a SIMPLE IRA?
A Savings Incentive Match Plan for Employees (SIMPLE) is a retirement plan for small businesses with fewer than 100 employees that can be set up as either a 401(k) or an IRA. It comes with fewer restrictions and paperwork than other types of workplace retirement plans. It is a great starter plan for freelancers, consultants, or small businesses that want to minimize their administrative hassles. I didn’t discuss the SEP-IRA in this article, but it’s also another good choice.
With a SIMPLE IRA, employees elect to make contributions on a pre-tax basis and employers must contribute a set amount of matching funds. For 2013, a worker can contribute 100% of their compensation up to $12,000 or $14,500 if you’re age 50 or older.
Employers must kick in SIMPLE IRA contributions on a dollar-for-dollar basis up to 3% of an employee’s compensation or make nonelective contributions of 2% of each employee’s compensation. Employees are always 100% vested in employer contributions.
Getting an IRA started at any age is always a smart money move toward helping make work optional some day. Many Gen X and Gen Y clients are depending on their 401k’s to do all of the work for their retirement, and the truth is for most it simply won’t be enough. Using one or multiple tax-advantaged IRAs is a smart way to make your investment dollars go farther and to make sure you’ll have a healthy nest egg to spend during the day you make work become optional.
Written by:
CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®
Editor in Chief of Your Smart Money Moves
Co-CEO and Founder of oXYGen Financial, Inc - The Leaders in Gen X & Y Financial Advice and Services
Ted Jenkin is one of the foremost knowledgeable professionals in giving financial advice to the X and Y Generation.
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What do you think is the best option for someone like me, who is a single-member LLC that wants to shelter their revenue from taxes?
It really depends on what the net income level in general looks like in the business. If there isn’t a ton of net profit (roughly 50k or under) I am a bigger fan of the Simple IRA. Remember this needs to be set up by October 1st of this year if you are going to do it for 2013. If your profit runs higher than 50k, it will make sense to look at a SEP IRA or Solo 401k depending on how much cash flow you can save.
how would you respond to the idea that taxes have nowhere to go but up so putting money into something like a traditional IRA might be a huge mistake if you plan on making more money or having fewer deductions in the future?
I guess the Roth IRA would be a good choice……
I think this is an excellent question. Obviously if you can qualify for a Roth IRA and/or a Roth 401(k) at work it would be a really good idea to sock money away into these vehicles especially if your current tax rate is low. What I think will be fundamentally true is that tax management will be just as important if not more important than asset management over the next decade. You need to consider today what will be the best short, medium, and long term tax management strategies to optimize future distributions.